In China, Economics Is Politics

As the Bo Xilai and Chen Guangcheng episodes show, politics in China can be brutal. For the Chinese Communist Party, an enduring social compact with its people is still a long way off. When it comes to economic management, though, the assumption is that China’s authoritarian leaders are streets ahead, since they have to deliver prosperity to remain in power. So when industrial production falls, fixed-asset investment and retail spending slows, and home sales plummet, Beijing worries. Export sales growth in April was only half of what it was in March—results that surprised even Premier Wen Jiabao.

The problem is not the growth level itself, since the world’s second-largest economy is presumably still tracking for about 7 percent to 8 percent expansion in 2012. The concern is that all drivers of GDP growth appear to be faltering. There was once almost blind consensus in the West that authoritarian politics was good for China’s economy. This is now increasingly being called into question, and with good reason.

The mantra for several years has been to “rebalance” the Chinese economy. This means avoiding overreliance on fixed investment and exports and shifting toward greater reliance on domestic consumption to drive GDP growth.

There is an economic and social logic to this mantra. Fixed investment overtook exports as the primary driver of Chinese growth in the first few years of this century. Prior to the global financial crisis, fixed investment was responsible for about 40 percent of growth each year. In 2009-10, it drove at least 80 percent of growth following the doubling of bank loans and the influx of cheap capital into infrastructure and property projects. Currently, fixed investment is driving at least half the country’s economic growth.

The use of capital is becoming more and more inefficient, however. For example, the capital factor productivity ratio (amount of capital inputs required to produce one additional dollar of output) at the turn of the century was about 3 to 1. It is now at least 7 to 1, if not higher. The increasingly inefficient use of capital is a sure precursor to the dangerous rise in nonperforming loans (NPLs), which plagued the Chinese banking system a decade ago.

High fixed-asset investment and low domestic consumption also have social ramifications. Growing economic wealth ultimately matters because it allows improvement in the material lives of the population. While the revenues of centrally and locally managed state-owned enterprises (SOEs) have been increasing by about 20 percent to 25 percent per annum over the past 10 years, wages, salaries, and household income from interest and investment dividends have been falling.

In other words, the savings of the Chinese people are effectively subsidizing fixed-asset investment by SOEs, which receive at least three-quarters of all bank loans. While fixed-asset investment has shot up by an average of 20 percent to 30 percent each year over the decade, domestic consumption as a proportion of GDP has declined from about 48 percent to 33 percent, the lowest of any major economy in the world. With a GDP per capita barely inside the world’s top 100, China’s spectacular economic growth is not being translated proportionately into better material outcomes for a majority of the population.

In the next few years, domestic consumption has to rise. Government redistribution—through increased welfare spending and tax breaks for the poor—will generally improve outcomes only at the margin. The key to expanding domestic consumption is to increase private household incomes. And the only way to do this is to severely curtail lending to the state-owned sector, dramatically ramp up formal bank lending to the 5 million to 10 million private companies throughout the country (which currently have to pay off-market rates of 25 percent to 100 percent in informal lending markets), and open up the most lucrative and important sectors of the economy to domestic private-sector companies.

For proof this will work, consider the changes that took place in the first stage of Deng Xiaoping’s economic reforms. From 1979 to 1989, increases in domestic consumption drove about half of the country’s GDP growth. In that decade, more than 70 percent of the country’s capital was directed to privately run businesses (many of which formally existed under a “cooperative” ownership structure). Because millions of these businesses had ample access to capital—and having privileged connections was not an important prerequisite for receiving a loan—the increase in household income was far more evenly spread than today.

Even though China has been growing at close to 10 percent since the early 1980s, inequality took off only from the mid-1990s onward—a period that coincided with the dramatic increase in fixed-investment activity by SOEs. Indeed, 80 percent of the poverty reduction since 1979 took place in the first 10 years of reform, a period before the return of dominant SOEs.

The domestic private sector is also far more efficient at using capital and generating jobs than are SOEs. Besides raising household income, diluting the economic privileges of SOEs would also significantly improve loan quality and reduce undoubtedly dangerous levels of hidden NPLs in the financial system.

The rise of SOEs in the mid-1990s occurred to ensure that the economic entities controlled by the Communist Party remained the dominant commercial players in key sectors. The broader purpose was to ensure that the party remained the dominant dispenser of economic, commercial, and career opportunity in the country, enhancing the relevance of the party, and therefore its standing, among the country’s existing and emerging elites.

Since then, the interests of China’s SOEs have merged with interests of powerful factions within the party. That’s especially true of the princelings, the group of well-connected sons and daughters of former leaders that includes deposed Chongqing party boss Bo Xilai and the incoming president, Xi Jinping. As Xi and others in the next generation of Chinese leaders prepare to take charge, they must face up to a challenge their predecessors ignored: What is good politics for the Communist Party is no longer good economics for the country.